I lived and worked in Shanghai and Hong Kong for almost two decades and now write primarily on China, Asia, and nuclear proliferation. I am the author of two Random House books, The Coming Collapse of China and Nuclear Showdown: North Korea Takes On the World. My writings have appeared in The New York Times, The Wall Street Journal, Barron’s, Commentary, and The Weekly Standard, among other publications. I blog at World Affairs Journal. I have given briefings in Washington and other capitals and have appeared on CNN, Fox News, MSNBC, Fox Business, Bloomberg, CNBC, and PBS. I served two terms as a trustee of Cornell University.

China Stocks Surge: Time To Run With The Dragons?

Chinese equities soared in the last eight trading sessions in July. In a little more than a week, China went from one of the worst performers in the world to one of the best.

The widely followed Shanghai Composite shot up 7.2% from July 22 to the 31st. In the same period, the CSI 300 jumped 8.5%. Both indexes fell back on August 1, but only by small margins and largely due to U.S. concerns.

The Hang Seng China Enterprises Index, which tracks H-shares, has been on an upward swing since March, rising with the broader Hong Kong market. In the last eight trading sessions of July, the H-share index was up 6.2%.

“Optimism is in the air,” writes Jian Chang of Barclays Capital. Dr. Chang has got that right. Some analysts even characterize the recent gains as the prelude to a bull run next year. Given volatility in China, it’s premature to think about 2015 at this moment, yet we can say that trends over the next several months look particularly good.

There’s no mystery why China took off. Valuations there were depressed, indicators since June pointed to recovery, U.S. stocks looked pricey. Moreover, the boom in Asian equities was bound to rub off on China sooner or later. At some point, foreign investors had to send money to Chinese markets. There was no “if” to the movement upward; it was a “when.”

Now that the rally is finally occurring, the question is “How long?” This year two China rallies have already sputtered out.

The late-July surge, like many in the past, was built on central government money. The People’s Bank of China, the central bank, is continuing to flood the country with liquidity. M2, the broad gauge of money in circulation, was up 14.7% year-on-year in June.

Total social financing, the comprehensive measure of credit growth, skyrocketed 40.7% in June from the preceding month, largely the result of off-balance sheet credit. And it appears June loans largely went to state entities.

At the same time, Beijing also binged. In June, fiscal spending hit 1.652 trillion yuan, 26.1% more than in the same month last year.

The good news for China’s stock investors is that the central government has shown a clear determination to maintain growth. Premier Li Keqiang, the economic czar, talks about adopting “targeted measures” and rejecting “strong stimulus,” as he did last month, but in reality he has returned to the tactics of 2008 and 2009. Beginning in 2008, his predecessor, Wen Jiabao, splurged, dumping an unprecedented amount of cash into the economy. More money in circulation generally means stocks go up.

The bad news for investors is that Li, like Wen, has chosen growth over reform and just about every analyst believes there can be no long-term expansion without fundamental restructuring. Because of Beijing’s stimulus—most of it applied through the state sector—Li has led China even further away from a consumption-based model, the only sustainable one.

And to make matters worse, Beijing is incurring indebtedness at a rapid pace, perhaps as fast as 20% a year recently. As a result of the new obligations, China’s debt load looks heavy.

Standard Chartered Bank estimates the country’s debt was 251% of GDP at the end of Q2, but that number looks far too low. Even if that estimate captured all Chinese indebtedness—something exceedingly difficult to do with the proliferation of new forms of borrowing—the number is based on official estimates of the size of the economy. Official GDP estimates are at least 15% too large, perhaps 30%. Increase the numerator and shrink the denominator of that fraction, and the result exceeds the 300% mark.

Economies usually cannot grow with a 300% debt load, but for investors in Chinese stocks that does not matter. Apart from the famed Jim Rogers, few stock investors are willing to think about China with a long-term horizon. In the near term, Beijing can continue to pile up debt, create growth, and drive up equity markets, pretty much as it pleases.

So the recent Chinese upsurge looks like it has months to run. Individuals are trickling back, and so are foreigners. “There are clear signs that both domestic funds and foreign institutions are building positions in large-cap stocks in Shanghai recently,” says Chen Huiqin at Huatai Securities in Nanjing. A Reuters survey shows institutions will favor China this quarter. Be prepared to make money.

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